9 Cost Allocation for Joint Products and By-Products CHAPTER LEARNING OBJECTIVES After completing this chapter, you should be able to answer the following questions: 1 How are the outputs of a joint process classified? 2 At what point in a joint process are joint products identifiable? 3 What management decisions must be made before a joint process is begun? 4 How are joint costs allocated to products? 5 How are by-products treated in accounting systems? 6 How should not-for-profit organizations account for joint costs? Buckhead Beef Company INTRODUCING uckhead Beef Company, headquartered in Atlanta, is the largest provider of Certified Angus Beef ™ in the United States. Howard Halpern cofounded the com- pany in 1983, and the company currently has revenues approaching $300 million. Approximately 75 percent of Buckhead Beef’s sales are select, choice, and prime grades of steak. The rest of the company’s sales are pork, veal, lamb, game meats and birds, provisions, deli meats, and seafood. Buckhead’s truck fleet delivers products to customers in the southeastern and northeastern states, and through a distribution center in Puerto Rico, serves the Caribbean market. In addition, however, through the company’s steakhouse accounts, it achieves nationwide distribution. Customers also include hotels, country clubs, upscale retail outlets, and a small number of prestigious, well- established grocery stores. The company’s strength results, to some extent, from combining the expertise of an in-house cut shop with the efficiency of a large-scale distributor. Buckhead uses energy-efficient equipment in its USDA inspected plant and a state-of-the-art computerized bar coding system. This system allows the company to track products from the time they are processed at the packing plant to the time they are aged, portion-cut, vacuum-packed, and delivered to customers. The bar codes contain information on cost per pound and historical data such as production line and packaging date. Restaurant managers are particularly de- lighted with this technology. Buckhead has an open-book policy with its customers and sells on a true cost-plus basis. Almost every company produces and sells more than one type of product. Al- though companies may engage in multiple production processes to manufacture a variety of products, they may also engage in a single process to simultaneously generate various different outputs such as those of Buckhead Beef and its cus- tomers (meat processors cut, segment, process, and package meats from a side of beef). In a like manner, the refining of crude oil may produce gasoline, motor oil, heating oil, and kerosene. A single process in which one product cannot be man- ufactured without producing others is known as a joint process. Such processes are common in the extractive, agricultural, food, and chemical industries. The costs incurred for materials, labor, and overhead during a joint process are referred to as the joint cost of the production process. This chapter discusses joint processes, their related product outputs, and the accounting treatment of joint cost. Outputs of a joint process are classified based on their revenue-generating ability, and joint cost is allocated only to the primary products of a joint process, using either a physical or monetary measure. Although joint cost allocations are necessary to determine financial statement valuations, such allocations should not be used in internal decision making. 1 Joint costs may also be incurred in service businesses and not-for-profit orga- nizations. Such costs in these organizations are often for advertisements that pub- licize different product lines or locations, or ads for different purposes, such as public service information and requests for donations. Joint costs of not-for-profit firms are covered in the last section of this chapter. SOURCE : Adapted from Bob Swientek, “A Cut Above,” Prepared Foods (October 1998), Rising Stars feature section. Reprinted with permission of Cahners Business Information. 343 http://www.buckheadbeef.com B joint process joint cost 1 Sometimes, correct pricing of a product depends on knowledge of the full cost of making the product, particularly when contractual agreements require cost-plus pricing. Joint cost allocation is also necessary to the valuation of products, estimation of product line profitability, and (in some cases) determination of product selling price. Part 2 Systems and Methods of Product Costing 344 OUTPUTS OF A JOINT PROCESS A joint process simultaneously produces more than one product line. The product categories resulting from a joint process that have a sales value are referred to as (1) joint products, (2) by-products, and (3) scrap. Joint products are the primary outputs of a joint process; each joint product individually has substantial revenue- generating ability. Joint products are the primary reason management undertakes the production process yielding them. These products are also called primary prod- ucts, main products, or coproducts. Joint products do not necessarily have to be totally different products; the de- finition of joint products has been extended to include similar products of differ- ing quality that result from the same process. For example, when an oil refinery processes petroleum into gasoline, the outputs will all have been derived from pe- troleum, but different grades will have more octane and other characteristics based on the extent and types of additional processing. In contrast, by-products and scrap are incidental outputs of a joint process. Both are salable, but their sales values alone would not be sufficient for manage- ment to justify undertaking the joint process. For example, donut hole cutouts are a by-product of the donut-making process. Scrap may be generated in the setup stage. Contractors may tear out old fixtures, cupboards, etc., in remodeling a home. Such items are often resold to other contractors. 2 By-products are viewed as having a higher sales value than scrap. A final out- put from a joint process is waste, which is a residual output that has no sales value. A normal amount of waste may create a production cost that cannot be avoided in some industries. Alternatively, many companies have learned either to minimize their production waste by changing their processing techniques or to re- classify waste as a by-product or scrap through selling it to generate some mini- mal amount of revenue. A company may change a product classification over time because of changes in technology, consumer demand, or ecological factors. Some products originally classified as by-products are reclassified as joint products, whereas some joint prod- ucts are reduced to the by-product category. Even products originally viewed as scrap or waste may be upgraded to a joint product status. Years ago, for exam- ple, the sawdust and chips produced in a lumber mill were considered waste and discarded. These items are now processed further to produce particleboard used in making inexpensive furniture. Therefore, depending on the company, sawdust and chips may be considered a joint product or a by-product. Sometimes a by- product will be accidentally discovered by good fortune. An interesting example is found in the Internet revolution in the News Note on page 345. Classification of joint process output is based on the judgment of company managers, normally after considering the relative sales values of the outputs. Clas- sifications are unique to each company engaged in the joint process. For exam- ple, Lazy-K Ranch and Sterling Steers Ltd. each engage in the same joint produc- tion process that produces three outputs: meats, bone, and hide. Lazy-K Ranch classifies all three outputs as joint products, whereas Sterling Steers Ltd. classifies meats and hide as joint products; bone is regarded as a by-product. These classi- fications could have resulted from the fact that Lazy-K Ranch has the facilities to process bone beyond the joint process, but Sterling Steers does not have such fa- cilities. Further processing endows bone with a substantially higher sales value per unit than selling bone as it exits the joint process. How are the outputs of a joint process classified? joint product 1 by-product scrap waste 2 Recycling is a related issue. Now, about 75 percent of a car’s weight can be recycled. (Nissan is close to recycling 90 per- cent.) Companies are working to similarly recycle waste of other products. http://www.bestfoods.com http://www.genmills.com http://www.nestle.com http://www.perrier.com http://www.tropicana.com Chapter 9 Cost Allocation for Joint Products and By-Products 345 Can You Believe It? NEWS NOTEGENERAL BUSINESS E-commerce infomediaries are finding that as they mend broken supply chains, one by-product is aggregated purchase data that have never been available before. Such is the case with Instill Corp., (http://www.instill .com) which provides an e-marketplace for the food-ser- vices industry. Last week the company added a new ser- vice called Instill Market Intelligence, which offers sub- scriptions to the purchase data generated by buyers on its systems. Who is willing to pay its six-figure price tag? Some of the world’s largest food manufacturers, including Bestfoods, General Mills, Nestle, Perrier, Schreiber, and Tropicana. These vendors have never had access to data about the amount of product being purchased by restaurants and other food-services outlets, such as hospitals. That’s because sales in the industry are handled by thousands of regional distributors, making it difficult to get an ac- curate, aggregated view of purchase data—not just ship- ment figures—across the manufacturer’s segments, cat- egories, and products. Access to that data will now let manufacturers, such as Bestfoods, better manage production, plan new prod- ucts, and market and sell existing products to the best- suited buyers, according to T.C. Chatterjee, senior busi- ness manager at Bestfoods. “For the first time, we are able to support sales and marketing efforts based on actual operator purchases,” said Trevor Farrell, customer supply-chain manager at Schreiber Foods Inc., another Instill subscriber. “Using the data to standardize the industry is an ab- solute must as a first step in a fragmented industry,” said Forrester Research Inc. (http://www.forrester.com) ana- lyst Bruce Temkin. “To sell the data back to manufactur- ers is a big win. Over time, distributors will be forced to operate in a more competitive environment, and you’ll see more dynamic pricing.” Food manufacturers have long had market-share data from in-store supermarket sales via data providers such as IRI or Neilsen. But in the food-services area, they have relied on educated guesses as to how their products stack up against competitors. SOURCE : Richard Karpinski, “Infomediary Repackages Sales Data for Vendors,” Internetweek (September 27, 1999), p. 8. THE JOINT PROCESS Joint products are typically produced in companies using mass production processes and, thus, a process costing accounting method. 3 The outputs of a corn process- ing plant, for example, may include corn on the cob and whole-kernel corn (joint products), partial corn kernels (by-product) used for corn meal and grits, inferior kernels (scrap) for sale to producers of animal food, and husks, corn silk, and cobs (waste) that are discarded. Exhibit 9–1 illustrates the output of such a joint process. The point at which joint process outputs are first identifiable as individual prod- ucts is called the split-off point. A joint process may have one or more split-off points, depending on the number and types of output produced. Output may be sold at the split-off point if a market exists for products in that condition. Alter- natively, some or all of the products may be processed further after exiting the joint process. Joint cost includes all costs incurred up to the split-off point for direct mate- rial, direct labor, and overhead. Joint cost is allocated, at the split-off point, to only the joint products because these products are the reason that management under- took the production process. Allocation is necessary because of the cost principle. Joint cost is a necessary and reasonable cost of producing the joint products and, therefore, should be attached to them. Although necessary for valuation purposes At what point in a joint process are joint products identifiable? 2 3 For simplicity, Chapters 6 and 7 on process costing included examples of only single-product processes. split-off point for financial statements, the joint cost allocation to joint products is, however, not relevant to decision making. Once the split-off point is reached, the joint cost has already been incurred and is a sunk cost that cannot be changed regardless of what future course of action is taken. If any of the joint process outputs are processed further, additional costs after split-off will be incurred. Any costs after split-off are assigned to the separate prod- ucts for which those costs are incurred. Exhibit 9–2 depicts a joint process with multiple split-off points and the allocation of costs to products. For simplicity, all output of this joint process is considered primary output; there are no by- products, scrap, or waste. Note that some of the output of Joint Process One (joint Part 2 Systems and Methods of Product Costing 346 EXHIBIT 9–1 Illustration of Joint Process Output Raw Material Input— Fresh Corn Joint Process— Shucking and Cleaning Joint Process Outputs Corn on the cob (Joint Product)— will be bagged and sold. Whole kernels (Joint Product)— will be added to water and sugar, canned, and sold. Partial kernels (By-product)— will be ground to make corn meal or grits and sold. Husks, corn silk, and cobs (Waste)— will be discarded. Inferior kernels (Scrap)— will be sold to manufacturers of animal food. sunk cost products B and C) becomes part of the direct material for Joint Process Two. The joint cost allocations will follow products B and C into Joint Process Two for ac- counting purposes, but these allocated costs should not be used in making deci- sions about further processing in that department or in Department Four. Such de- cisions should be made only after considering whether the expected additional revenues from further processing are greater than the expected additional costs of further processing. Chapter 9 Cost Allocation for Joint Products and By-Products 347 EXHIBIT 9–2 Model of a Joint Process Product A is warehoused or sold. Product C is warehoused or sold. Incur DM, DL, and OH costs for joint products. Department One JOINT PROCESS ONE Product A is separately processed further; additional costs of DM, DL, and OH are totally assignable to Product A. Department Two PRODUCT A PROCESSING Incur DM, DL, and OH costs for joint products B and C. Department Three JOINT PROCESS TWO PRODUCT B and C PROCESSING Product B is warehoused or sold at split-off point. Product C is separately processed further; costs of DM, DL, and OH are totally assignable only to Product C. Department Four PRODUCT C PROCESSING Split-off point; joint products A, B, and C are produced. Allocate costs of Joint Process One to joint products A, B, and C. Split-off point; allocate costs of Joint Process Two to joint products B and C. Part 2 Systems and Methods of Product Costing 348 MANAGEMENT DECISIONS REGARDING JOINT PROCESSES Certain decisions need to be made by company managers before committing re- sources to a joint production process. First, total expected revenues from the sale of the joint process output must be estimated and compared to total ex- pected processing costs of the output. If the revenues are expected to exceed the costs, management must then consider other potential costs. Because the joint process results in a “basket” of products, managers must be aware that some of the joint process output may require additional processing to make it salable. Once joint process costs have been incurred, they become sunk costs regardless of whether the output is salable at the end of the joint process or at what amount. Thus, management must consider total joint costs plus expected separate processing and/or selling costs incurred at or after the end of the joint process in making the decision about whether to commit resources to the joint process. If total anticipated revenues from the “basket” of products exceed the antici- pated joint and separate costs, the second management decision must be made. Managers must compare the net income from this use of resources to that which would be provided by all other alternative uses of company resources. If joint process net income were greater than would be provided by other uses, manage- ment would decide that this joint production process is the best use of capacity and would begin production. The next two decisions are made at split-off. The third decision is to deter- mine how the joint process output is to be classified. Some output will be primary; other output will be considered to be by-product, scrap, or waste. This classifica- tion decision is necessary for the joint cost to be allocated, because joint cost is only assigned to joint products. However, before allocation, joint cost may be re- duced by the value of the by-products and scrap. Determination of by-product and scrap value is discussed later in the chapter. The fourth decision is the most complex. Management must decide whether any (or all) of the joint process output will be sold at split-off or whether it will be processed further. If primary products are marketable at split-off, further pro- cessing should only be undertaken if the value added to the product, as reflected by the incremental revenue, exceeds the incremental cost. If a primary product is not marketable at split-off, additional costs must be incurred to make that product marketable. For nonprimary output, management must also estimate whether the incremental revenue from additional processing will exceed additional processing cost. If there is no net benefit, the nonmarketable output should be disposed of without further processing after the split-off point. To illustrate a further-processing decision, assume that a whole turkey has a selling price of $0.18 per pound at split-off, but the minimum selling price for turkey parts after further processing is $0.23 per pound. If the additional process- ing cost is less than $0.05 per pound, the $0.05 incremental revenue ($0.23 Ϫ $0.18) exceeds the incremental cost, and additional processing should occur. Note that the joint cost is not used in this decision process. The joint cost is a sunk cost after it has been incurred, and the only relevant items in the decision to process further are the incremental revenue and incremental cost. Exhibit 9–3 presents the four management decision points in a joint pro- duction process. In making decisions at any potential point of sale, managers must have a valid estimate of the selling price of each type of joint process out- put. Expected selling prices should be based on both cost and market factors. In the long run, assuming that demand exists, the selling prices and volumes of products must be sufficient to cover their total costs. However, immediate eco- nomic influences on setting selling prices, such as competitors’ prices and con- sumers’ sensitivity to price changes, cannot be ignored when estimating selling prices and forecasting revenues. What management decisions must be made before a joint process is begun? 3 Chapter 9 Cost Allocation for Joint Products and By-Products 349 EXHIBIT 9–3 Decision Points in a Joint Production Process Do not produce Do not produce Determine best use at split-off Sell at split-off YES NO NO Begin production and incur costs for materials, labor, and overhead Allocate joint cost YES SPLIT-OFF POINT Revenues > expenses for basket of goods? NO YES YES NO Joint Product? YES NO NO Marketable? (1) (2) (3) (4) Best use of facilities? Incremental profit after addi- tional processing > zero after split-off? Are added revenues after additional processing > additional costs? Incur additional costs Sell Part 2 Systems and Methods of Product Costing 350 Melted wax can be made into scented or unscented candles as well as into candles of differ- ent sizes and shapes, with or without a container. The cost of getting the wax to this stage is a joint cost that should be allo- cated among the types of prod- ucts to be manufactured. ALLOCATION OF JOINT COST Delectable Edibles Company is used to demonstrate alternative methods of allo- cating joint processing cost. Because the consumer market for large portions of large farm animals is limited, Delectable Edibles processes sides of beef into three distinct primary products during a joint process: steaks, roasts, and ground meat. (The remaining parts are considered by-products.) All joint products can be sold at split-off. Alternatively, each beef product can be processed further, which will create additional separate costs for the products. Steaks can be processed further to produce steak sandwiches; roasts can be processed further to make special cuts; and ground meat can be processed further to be used as part of a sausage mix- ture. Certain marketing and disposal costs for advertising, commissions, and trans- portation are incurred regardless of when the products are sold. Assumed infor- mation on Delectable Edibles’ processing operations and joint products for October 2000 is presented in Exhibit 9–4. Physical Measure Allocation An easy, objective way to prorate joint cost at the split-off point is through the use of a physical measure. Physical measurement allocation uses a common physical How are joint costs allocated to products? 4 Joint processing cost for period: $5,400,000 (1) (2) (3) (4) (5) (6) Sales Price Selling Cost per Separate Cost Final Sales Joint Tons of per Ton Ton Regardless per Ton if Price Products Production at Split-Off of When Sold Processed Further per Ton Steaks 3,800 $2,800 $200 $100 $3,200 Roasts 2,400 1,800 100 100 2,100 Ground 2,800 1,200 50 60 1,500 EXHIBIT 9–4 Basic Joint Cost Information physical measurement allocation characteristic of the joint products as the proration base. All joint products must be measurable by the same characteristic, such as • tons of ore in the mining industry, • linear board feet in the lumber milling industry, • barrels of oil in the petroleum refining industry, • tons of meat, bone, and hide in the meat packing or processing industry, or • number of computer chips in the semiconductor industry. Using physical measurement allocation, Delectable Edibles’ $5,400,000 of joint cost is assigned as shown in Exhibit 9–5. For Delectable Edibles, physical mea- surement allocation would assign a cost of approximately $600 ($5,400,000 Ϭ 9,000 tons) per ton of beef, regardless of type. Physical measurement allocation treats each unit of output as equally desirable and assigns the same per-unit cost to each. Also, unlike monetary measures, phys- ical measures provide an unchanging yardstick of output. 4 A ton of output pro- duced from a process 10 years ago is the same measurement as a ton produced from that process today. Physical measures are useful in allocating joint cost to products that have extremely unstable selling prices. These measures are also nec- essary in rate-regulated industries that use cost to determine selling prices. For ex- ample, assume that a rate-regulated company has the right to set selling price at 20 percent above cost. It is circular logic to allocate joint cost based on selling prices that were set based on cost to produce the output. A major disadvantage of allocating joint cost based on a physical measure is that the method ignores the revenue-generating ability of individual joint products. Products that weigh the most or that are produced in the largest quantity will re- ceive the highest proportion of joint cost allocation—regardless of their ability to bear that cost when they are sold. In the case of Delectable Edibles, each ton of ground has been assigned a cost of $600. However, computations will demonstrate that ground generates the lowest gross profit of the three joint products and yet is being assigned the same joint cost per ton as the more desirable steaks and roasts. Monetary Measure Allocation All commonly used allocation methods employ a process of proration. Because of the simplicity of the physical measure allocation process, a detailed proration Chapter 9 Cost Allocation for Joint Products and By-Products 351 Cost per Physical Measure ϭ Total Joint Cost Ϭ Total Units of Physical Measurement ϭ $5,400,000 Ϭ 9,000 tons ϭ $600 Joint Cost Total Product per Ton per Ton Allocated Cost Steaks 3,800 $600 $2,280,000 Roasts 2,400 600 1,440,000 Ground 2,800 600 1,680,000 Total 9,000 $5,400,000 EXHIBIT 9–5 Joint Cost Allocation Based on Physical Measurement 4 There are occasional exceptions to the belief that physical measures provide an unchanging yardstick of output. To illustrate, many grocery products have been downsized in recent years. For example, coffee was formerly sold in one-pound containers; now it is customarily sold in 13-ounce packages. [...]... What amount of joint cost should be allocated to the Shirts and Pants products? b What are the sales values at split-off for Hats and Shirts? c Which products should be processed further? Show computations d If 4,000 Shirts are processed further and sold for $67,000, what is gross profit on the sale? 371 Chapter 9 Cost Allocation for Joint Products and By -Products 31 (By -products and cost allocation) ... Systems and Methods of Product Costing SOLUTION STRATEGIES Allocation of Joint Cost Joint cost is allocated only to joint products; however, joint cost can be reduced by the value of by-product/scrap before the allocation process begins For physical measure allocations: Divide joint cost by the products total physical measurements to obtain a cost per unit of physical measure For monetary measure allocation: ... section; and Barbara Young-Huguenin, “Aged to Perfection,” The National Provisioner (1998) Chapter 9 Cost Allocation for Joint Products and By -Products CHAPTER SUMMARY Multiple products from a joint process are defined (based on market value) as joint products, by -products, and scrap A residual product that has no market value is called waste Joint process cost is allocated solely to joint products. .. values at split-off For October, the approximated net realizable values at splitoff were $158,910 for perfume and $52,970 for lotion a Prepare journal entries for the Mixing and Cooking Departments for October 2000 b Determine the joint cost allocated to, and the total cost of, Elegance and Sooosoft c Diagram the flow of costs for Madeleine Products for these two products 40 (Joint cost allocation; by-product;... performed by the organizations 362 Part 2 Systems and Methods of Product Costing JOINT COSTS IN SERVICE AND NOT -FOR- PROFIT ORGANIZATIONS 6 How should not -for- profit organizations account for joint costs? http://www.arthurandersen com Service and not -for- profit organizations may incur joint costs for advertising multiple products, printing multipurpose documents, or holding multipurpose events For. .. split-off and cost allocations) Planetary Products has a joint process that makes three products Joint cost for the process is $30,000 Product Sun Moon Mars Units of Output Per Unit Selling Price at Split-Off Incremental Processing Costs Final Sales Price 5,000 10,000 250 $2.00 1.00 1.50 $1.50 2.00 0.20 $3.00 6.00 1.80 369 Chapter 9 Cost Allocation for Joint Products and By -Products Sun, Moon, and Mars... reduction in the Cost of Services Rendered for the main services Separate costs for the two main services for June were $250,000 and $180,000, respectively, for checking accounts and credit cards a Allocate the joint cost b Determine the income for each main service and the company’s overall gross margin for June 2000 41 (Joint cost allocation; scrap) Washington Filaments produces cloth products for hotels... promotion costs to the two divisions using change in revenue b Allocate the total promotion costs to the two divisions using change in net income before joint cost allocation c Which of the two approaches is most appropriate? Explain 29 (By -products and cost allocation) Bayshore Manufacturing has a joint process that yields three products: M, N, and O The company allocates the joint cost to the products. .. Chapter 9 Cost Allocation for Joint Products and By -Products c further processed and transferred to finished goods, with joint cost being allocated between wheat and straw based on relative sales value at the split-off point (CPA adapted) CASE 46 (Ending inventory valuation; joint cost allocation) Gainesville Meat Packers experienced the operating statistics in the following table for its joint meat... $62,300 0.65 0.35 1.00 Joint Cost $65,000 65,000 Per Ton Approximated NRV Total Approximated NRV Decimal Fraction $1,164 1,290 $52,380 25,800 $78,180 0.67 0.33 1.00 Joint Cost $65,000 65,000 Joint Cost $65,000 65,000 Allocation of Joint Cost $41,600 23,400 $65,000 Allocation of Joint Cost $42,250 22,750 $65,000 Allocation of Joint Cost $43,550 21,450 $65,000 QUESTIONS 1 What is a joint production process? . of a joint process—by -products and scrap. Chapter 9 Cost Allocation for Joint Products and By -Products 355 Part 2 Systems and Methods of Product Costing. be made before a joint process is begun? 3 Chapter 9 Cost Allocation for Joint Products and By -Products 349 EXHIBIT 9–3 Decision Points in a Joint Production